The Wall Street Meltdown for Dummies

TO HEAR television’s talking heads tell it, the world spent last week doing its best to come to a financial end. Wall Street’s Armageddon is here. Buddy Holly has died again and Don McLean is penning a second act. The most frightening aspect of the whole stock market melt down week might just be trying to figure out what’s happened.

In a way America is, as Timeput it last Friday, stuck in a kind of horror flick. But the monster out to get us in this film is fear. The more scared we are of a financial crisis, the greater our woes. Fear has driven some of Wall Street’s biggest names into bankruptcy, and—like with most troubled teens—the problems began at home.

It started when the decline in home values tripped up mortgage lenders. During the housing boom, banks began giving loans to high-risk borrowers for big fees. If you had bad credit, banks would give you a “subprime mortgage” that had a low interest rate for a few years, but then would triple or more. People who got these subprime mortgages knew they couldn’t pay for their homes once the interest rate shot up, so they would buy and then sell before rates went up.

When the housing bubble burst, everyone was stuck with their home because no one was buying houses anymore. And when massive numbers of people began defaulting on their loans, banks were stuck without the money they had given away. Even as banks repossess homes, they can’t do anything with them because no one is buying houses.

Major banks and investment firms own significant amounts of these bad mortgages and that is what’s pushing them into bankruptcy. The stock market’s speculative nature compounds the problems.

When investment bank Lehman Brothers ran out of money due to losses from subprime mortgages, Wall Street brokers began selling Lehman shares. This stripped money away from Lehman rapidly, accelerating its fall. Other companies considered loaning them cash to stay alive, but the companies decided they would never get it back. Thus, bankruptcy.

At the same time, another one of Wall Street’s biggest financial firms, Merrill Lynch, was selling themselves to Bank of America to avoid the same troubles Lehman was having. They were successful in finding private funds while Lehman was not, but it still meant a major name disappearing from the landscape of the American economy. It would be similar to eliminating Jimi Hendrix from music history.

All of a sudden, Wall Street thought the world was ending and began a massive sell-off, sending the stock market plunging into the red. This caused an increase in problems for AIG, a major insurance corporation. Fearing another drop in the stock market, the government gave them cash to avoid a repeat of the Lehman bankruptcy. Ironically, the stock market dropped anyway, and only after savvy buyers saw low prices did the market fully recover its losses near the end of the week.

While the speculative system that led to the meltdown creates a potentially unstable financial structure, it is a necessary evil in order to grow an economy. There is no better way for people to invest in the future of American companies. Every time the stock market has taken a loss it has recovered because at some point, the price will be low enough that people will want to buy. The question is, how much financial pain can we endure?

Now Congress is considering another bailout measure. They have already nationalized AIG and the mortgage companies Fannie Mae and Freddie Mac so that they can stay in business (essentially buying them by force and operating them like the post office or DMV). This new plan will buy all the bad subprime mortgages from banks that are stuck with them so that companies won’t be in trouble anymore. If this works the way the government wants it to—and we all know how flawlessly government plans usually work out—it will keep companies from going bankrupt, take fear away from Wall Street, and give life to the housing market.

Oh, and it will cost American taxpayers $700 billion. Or, to put it more precisely, $700,000,000,000.

At first blush all these government actions, along with other regulations like criminalizing “short selling” (betting that companies will do badly), seem to be necessary. And if America were only going to be a country for another five years they would be. But they have drastic ramifications for the future.

Giving money to companies because they have made bad investments only encourages them to do it again. The government has declared some companies “too big to fail.” Firms can now take big risks, collecting the reward if successful, and charging the American taxpayer if they fail. It’s a philosophy that Washington has followed since the 1980’s, and it’s been a problem ever since.

The bailouts pushing America billions deeper into debt won’t solve our problems in the end. Congress should make the hard decision to let companies fail. If not, we’ll face this day again in the future, as firms lean again on the taxpayers, expecting them to cover their failures. Save yourself, as Roger Waters warned: Money, it’s a gas. / Grab that cash with both hands and make a stash.

Anthony Randazzo is the Charles G. Koch Associate at the Reason Foundation in Washington, D.C. He contributes to Reason on finance and economic policy.